Caterpillar Slips: Chanos is Short as Commodity ‘Super Cycle’ Comes to an End

By Tiernan Ray

Noted short seller Jim Chanos a short while ago told the audience at the CNBC “Delivering Alpha” conference in New York that his big new idea is shorting Caterpillar (CAT), whose operating profit margin will likely “revert to the mean” or lower as a global mining equipment boom prompted by China‘s housing boom, cools.

Caterpillar stock is down $2.19, or 2.4%, at $85.98, reversing earlier gains.

Chanos began his talk briefly noting that Hewlett-Packard (HPQ) is still one of his favorite short sales.

“We are still short HP, and for the additional reason now that the services business that everyone loves is now coming apart. For everyone who hopes HP and Dell (DELL) have a savior in the services business, they’re going to be disappointed.”

Then Chanos turned to extended remarks on Caterpillar and China:

The commodity super-cycle that’s been built on the back of the Chinese construction boom is coming to an end. The Chinese construction boom shows no sign of ebbing at the moment. If you consider that one company in the Dow Jones has 30% of its revenue tied to global mining capex, and 50% of its operating profit tied to global mining capex, and that global mining capex grew 8% per year from 1990 to 2001, the first up leg in global commodity super cycle, and then in the last four years grew at a 24% annual clip, and that one third of global mining capex is equipment, that lands you at the door step of Caterpiller. We are short Caterpiller. It is an iconic American company, a leader in its class, but it is in the wrong products at the wrong time in the cycle. Now, earnings are not expected to grow reasonably at all next few years. The bulls expect capex to decline in mining. But that’s expected to be gradually so, at perhaps 10% to 15% per year. But if you realize that capex in mining was $30 billion in 2006, 2007, and then got to $145 a couple years ago, those declines are still meaningfully above what were historical levels. So these are really staggering levels the globe has taken on to build out the Chinese real estate and infrastructure bubble. Operating margins [for Caterpillar] were as low as 4% a couple years ago, and they are now at 13%. One of the simplest aspects of economics that has been suspended in this cycle is reversion to the mean in profit margin. I think it’s going to revert with a viciousness in the next couple years. If it were to go back to even median operating profit margins, [Caterpillar's] earnings would go to $5 to $6 area. [Note: Caterpillar profit is projected at $6.78 this year.] if it went worse, profit could go down to $3 to $4. And then, there are also accounting issues, which I always love. The company has negative free cash flow. It doesn’t have financial flexibility. But that’s not the only thing. In buying [equipment maker] Bucyrus a couple of years ago, Caterpillar took huge charges prior to the merger. That’s one of my favorites, companies writing down net tangible assets to zero. We think that charge has benefitted the company in the last 12 to 18 months. That may have boosted earnings, we’re not sure, it’s hard to tell, but whenever you see a company claim earnings synergies by buying a company and writing down the net assets to zero, you have to say that the company either never made money, or you’re being a little aggressive with your accounting. Caterpillar is going to face a series of super-commodity headwinds. All this happening against the backdrop of China still expanding its investment. There are a couple ways you could win. We think there will be long-term to intermediate-term disappointment for the bulls in coming years.

Shares of Joy Global (JOYG) are down and shares of Deere (DE) are down $1.26, or 1.5%, at $82.70.

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